The Smith Company: a case on capital budgeting and real options

Abstract

Purpose

This paper aims to provide upper‐level accounting and/or finance students with a review of the intricacies of option pricing, discounted cash flow (DCF) capital budgeting decision models, various types of real options, how risk analysis of long‐term capital investments can be facilitated by explicit consideration of real options, and the role of sensitivity analysis in the analysis of capital investment projects with real options.

Design/methodology/approach

The paper describes a fictional company facing a risky capital investment proposal. Students evaluate the investment proposal using traditional DCF analysis (i.e. the net present value method), and then re‐run the analysis by incorporating the existence of real options into the analysis of the proposed investment. Finally, students see the value of using Crystal Ball software for conducting sensitivity analysis as part of the decision‐making process.

Findings

There are two primary conceptual lessons that students realize by completing this educational case: real‐options analysis is a conceptually correct and robust way to explicitly deal with project uncertainty, and failure to explicitly consider real options in the analysis of capital investment projects may result in suboptimal decision making.

Originality/value

This case covers all major real‐option topics required for the certified management accountant exam. Further, the case fills a void in the literature of accounting education as this literature pertains to the availability of case material regarding the use of real options as an extension to conventional capital budgeting techniques.

Citation

Shastri, K.A., Shastri, K. and Stout, D.E. (2011), "The Smith Company: a case on capital budgeting and real options", Managerial Finance, Vol. 37 No. 7, pp. 647-657. https://doi.org/10.1108/03074351111140289